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Newest Additions To Our Friedrich Charts

In 1989 I was four years into working on building what would later be called Friedrich and back then I read a book called “The Money Masters” by John Train, which changed my life . In that book, one of the chapters was about the portfolio manager of Source Capital = Mr. George Michaelis, whom I consider one of the greatest investors in history. In the Appendix of that book, is part of the Source Capital annual report to investors for December 31, 1985. Here is what George wrote then. The ratio that you see in the first paragraph is actually one of the foundation stones of Friedrich and plays a major part in my creation of the final algorithm. The reason that ratio is so powerful is because it allows one to determine a company’s actual rate of growth on Main Street by incorporating its return on equity along with the company’s dividend payout policy, which both speak volumes about how well managed a company is. What I look for in using what I call the “Michaelis Ratio” is a return of at least 15% or higher. Here for example is our Friedrich chart for Accenture (NYSE: ACN ) that includes the Michaelis Ratio listed for the first time. As you can see Accenture’s Michaelis Ratio came in at 30%, which is twice what I look for as the ideal for this ratio. When you factor in my other original ratios like FROIC and CAPFLOW, you have quite impressive results for the company. But in that chart you will also see the Watson Ratio and the Sherlock Debt Divisor. Obviously, I am a big fan of Sir Arthur Conan Doyle’s work and have named these two powerful ratios after his greatest creations. Having said that, what is the Watson Ratio? The Watson Ratio is one of 30 original abstract ratios that I have created, which along with many others make up Friedrich. This particular ratio deals with the relationship between a company’s free cash flow and its diluted earnings per share. It uses the free cash flow methodology that Arnold Bernhard (the founder of Value Line) created, which is basically cash flow – capital spending and divides that result by the company’s diluted earnings per share. In theory most companies should have (what I call a Bernhard Free Cash Flow) result equal to its diluted earnings per share, so an average result should be 100%. When a company is well managed you will see a result greater than 100%, like Accenture’s result above of 110%, which obviously tells us that Accenture’s Bernhard Free Cash Flow is 10% better than then Accenture’s diluted earnings per share. Thus we end up with bonus points. A major concern that I have these days in analyzing companies is the amount of debt each company takes on relative to its operations and whether management is abusing our current Fed inspired low interest rate policy. Debt as anyone knows, when used wisely, allows for what is called leverage and leverage can be extremely beneficial within means. On the other side of the coin, the use of debt can also be excessive and put a company’s future in jeopardy. So what I have done to determine if a company’s debt policy is beneficial or abusive is create the Sherlock Debt Divisor, which allows us to investigate debt in a different abstract way. What the Divisor does is punish companies that use debt unwisely and rewards those who successfully use debt as leverage. How do I do this? Well I take a company’s working capital and subtract its long term debt. I then divide that result by the company’s diluted shares outstanding, then multiply that result by (-1). So if a company like Accenture has a lot more working capital than long term debt, I reward it and punish others whose long term debt exceeds its working capital. The final result for Accenture came in at $100.13 but the closing stock price was $104.78, so I am rewarding Accenture’s management for doing a great job using leverage. How do I reward them? Well I do so by using $100.13 as my numerator and not $104.78 in all my ratio calculations performed by Friedrich. So since the valuation in the Numerator is less, each ratio naturally generates a much more favorable result than it would have had I used $104.78. What does a company that is not doing very well look like? Well here is the Friedrich chart for Chevron (NYSE: CVX ). First of all, Chevron pays about a 5.09% dividend yield, so the growth for the company on a Main Street is only 1.91% on a Michaelis scale (7%-5.09%). It’s Watson Ratio ratio tells us to avoid it as its free cash flow is a disaster relative to its reported diluted earnings per share. Finally the large debt that Chevron has on its books punishes the company by adding $8.84 to the numerator in all ratio calculations performed by our Friedrich Algorithm. The Max Value you see below uses a different methodology to come up with its result and sometimes that result is skewed as it relies exclusively on what is called the “discounted owners earnings using a two stage dividend discount model’ found in Hagstrom’s great book “The Warren Buffett Way”. The final “Market Value of the Company” you see in the table below is what I call the Max Value. My work also incorporates different free cash flows than Mr. Hagstrom uses as I use the MFCF = Mycroft Free Cash Flow and since my Mycroft Free Cash Flow for Chevron comes in at $-785 million, you are obviously going to end up with a negative result for Max Value. My True Value and Buy Prices are based exclusively on my own ratios and that is why they are positive as they incorporate many more things than free cash flow in the analysis. As you can see if you used the Max Value in 2014 for Chevron you would have sold it then and avoided watching its stock price go down to $69.58, which is the 52 week low for this year. So when operating with abstract ratios sometimes you get such results where the buy price is higher than the Max Value, but what we are trying to do with Friedrich is find companies that are consistent year in and year out, so we do not need to sell. We are looking for just 50 stocks to put two percent in to become fully invested out of 3000 stocks that we analyze as part of our research. There is no such thing as a perfect system as perfection is an illusion that can only be found as a word in a dictionary. Once an investor understands that, she or he automatically matures and becomes a more seasoned investor. Plato once said “Experience is what man calls his mistakes”. Therefore, Friedrich is the culmination of what I have learned over the last 30 years in creating the Friedrich Algorithm, through trial and error and through my personal experiences in the stock market as a Professional Analyst.

True Management Excellence Is Reasserting Its Power And Importance

Summary A weak market environment reveals weaknesses in companies that would go unnoticed in good or moderate times. Management excellence becomes critically important as economic stresses emerge. Excellence is achieved by integrity in relationships with three key constituencies. Only when the tide goes out do you discover who’s been swimming naked. –Warren Buffett A weak market environment reveals weaknesses in companies that would go unnoticed in good or moderate times. –David Merkel Would you rather invest your hard earned dollars with the best-run companies in the world or the worst? The answer may seem obvious but there are millions of people have their money invested with managers who are plainly bad. I have been one of them in the past and perhaps you have been as well. Over the past 6 years investors haven’t had to give quality of management much thought, as rising stock prices and profits have allowed us to overlook mistakes and bad decisions. This happy time has already begun to change. Regardless of what the economic future holds, it’s undeniable that stresses have developed in the global economic system. Quality of management is about to become a much more important factor in company fortunes. For years it is been reasonably easy for management to keep shareholders happy with regularly increasing stock prices and higher profits. As the quotes above suggest, in times of stress management becomes critically important. Quality of management could soon become the differentiator between success and failure — even life and death — on the corporate level. Identifying Excellence In Management With widespread improvements in common metrics like profits and stock prices, how do we differentiate? How do we tell where the truly excellent (and truly bad) management is? A more comprehensive approach is required. The vast majority of managements will fall in the middle range of quality, and time is best spent identifying the very best and worst. After all, these are the managements that will produce the most consequences for us as investors. In addition, sustained excellence does not flow from a single great leader. No one can deny the importance of Steve Jobs at Apple, Alan Mulally at Ford, or Jack Welch at General Electric, but great leaders aren’t forever and their performance is not often repeated by their successors. In fact, it is dangerous to trust your money to a single individual no matter how talented, as Apple after Jobs’s first departure and GE after Welch demonstrated. True excellence is a culture that endures over generations of executives. Superior management is identified by integrity in relationships with its three main constituencies: customers, shareholders, and employees. All three of these “pillars of excellence” are essential – none can be ignored. In times of stress deficiencies in any one will be magnified and threaten the success of the enterprise. Excellence in each area, however, will support the others and the entire company. They provide a complete and robust assessment of management when added to standard measures like return on equity, share prices and dividend growth. The Three Pillars Customers Excellence in the customer relationship starts with high quality products and services that are valued by customers. Well-known examples are Nike, Tesla, Google, Tiffany, Johnson & Johnson, Caterpillar, Deere, Union Pacific, Apple, and Boeing. A different example is Family Dollar (NYSE: FDO ) which, although the products it sells are ordinary, has a combination of selection and price that fills an important customer need. Another aspect is customer service, and there are many studies of the best and worst companies in this regard. A recent study by 24/7 Wall Street rated these at the top. Best: Amazon (NASDAQ: AMZN ) Chick-fil-a Apple (NASDAQ: AAPL ) Marriott (NASDAQ: MAR ) Kroger (NYSE: KR ) Fedex (NYSE: FDX ) Trader Joes Sony (NYSE: SNE ) Samsung ( OTC:SSNLF ) UPS (NYSE: UPS ) And these rated worst: Comcast (NASDAQ: CMCSA ) DirectTV (NASDAQ: DTV ) Bank of America (NYSE: BAM ) Dish Network (NASDAQ: DISH ) AT&T (NYSE: T ) AOL (NYSE: AOL ) Verizon (NYSE: VZ ) T-Mobile (NYSE: TMUS ) Wells Fargo (NYSE: WF ) Walmart (NYSE: WMT ) Obviously, customer service is more challenging in some industries than others. The survey recognizes this and has two sets of rankings: from all executives and experts within each industry. Employees Who better to say which are the best companies to work for than the employees themselves? Fortune and the Great Place To Work Institute have been doing comprehensive surveys of employees for 25 years produce an annual list of the 100 Best Places to Work . Their model is based on five dimensions: Credibility, Respect, Fairness, Pride and Camaraderie. The top ten public companies (fourteen of the top twenty-four are private) in 2015 are: Google (NASDAQ: GOOG ) Salesforce (NYSE: CRM ) Genentech ( OTCQX:RHHBY ) Camden Property Trust (NYSE: CPT ) Klimpton Hotels and Restaurants (NYSE: IHG ) NuStar Energy (NYSE: NS ) Stryker (NYSE: SYK ) Ultimate Software (NASDAQ: ULTI ) Workday (NYSE: WDAY ) Twitter (NYSE: TWTR ) In times of economic distress investors want to a part owner in companies with employees who support and have confidence in management, and are invested in the company’s success. This is achieved when management does the same for their employees. Shareholders This is perhaps the most complex of the three “pillars” of excellence. Continuing the survey theme, Fortune and the Hay Group compile an annual list of the most admired companies in America. There are some methodological issues with and it includes only the largest companies, but healthy financials and stock performance are major factors so it is useful in this regard. The full list is here . The top ten “All Stars” for 2015 are: Apple Google Berkshire Hathaway ( BRK ) Amazon Starbucks (NASDAQ: SBUX ) Walt Disney (NYSE: DIS ) Southwest Airlines (NYSE: LUV ) American Express (NYSE: AXP ) General Electric (NYSE: GE ) Coca Cola ( K O) Institutional Shareholder Services has been assessing corporate governance for over 30 years. They examine over 200 factors to rate boards of directors in four areas: board structure shareholder rights compensation audit risk & oversight It addresses important questions like Is the board of directors independent or controlled by the chairman? Is compensated reasonable or detrimental to shareholders? Is there overboarding — do they sit on so many boards that they have excessive time commitments and may be unable to fulfill their duties? The rankings are interesting. Apple scores near the top in three of the four areas, but is in the bottom decile in compensation. Companies like Google and Groupon (GRP) that have dual stock classes generally rate poorly. Shareholder input An important aspect of this pillar comes from the shareholders themselves. Shareholders are very vocal on sites like Yahoo and Seeking Alpha about their relationship with management. When unhappiness is expressed, it can be an important sign that management is not aligned with shareholder interests. Dissatisfaction can occur whenever a company is underperforming, so it’s important to distinguish between general grumbling and more specific concerns. Questions about things like management compensation, risk, dilution, and conflicts of interest merit attention. Recent examples of serious red flags include: Prospect Capital (NASDAQ: PSEC ): Many investors have criticized management compensation, honesty about nonperforming assets, and other issues. This comment is typical: Leopards don’t lose their spots. Those of us who owned in the 10 dollar range remember Mgt. sold more shares, raised their mgt. fees, then cut the dividend. Leaving us stockholders holding the bag. I’m out and staying out. American Realty Capital Properties (ARCP): Minor accounting issues blew the top off a company with excessive compensation, conflicts of interest, excessive risk-taking and more. Management and the company name have been changed to Vereit (NYSE: VER ), but the point is that big losses were avoided by investors who heeded problems which were well known before the blowup. The entire medical marijuana industry: Marijuana has attracted more serial fraudsters, incestuous management and shareholder abuse than any industry in living memory. For an unfortunately common example, see this article on Medical Marijuana ( OTCPK:MJNA ), trading at three cents a share and a long history of issuing new shares to insiders like Halloween candy. To see how pervasive shareholder abuse is in the industry, see this article and others by Anthony Cataldo. Standard Metrics of Effectiveness Standard metrics that directly affect the bottom line are still the most important area of management assessment. They show how skilled executives are as businesspeople and are clearly related to the shareholders relationship. Revenues and profits matter. Metrics like return on assets (ROA) and return on equity (ROE) show how efficiently management utilizes the resources available to them. Debt/equity and debt/earnings can show the degree of risk that management is exposing shareholders to. Conclusion Complacency is deadly. For six years investors have been lulled into a sense that picking investment winners is easy, or at least something they have largely mastered. Conditions are changing however, in ways that will make successful management more challenging and will separate the good from the bad. Recognition of excellent management will be more critical to investment success and in some cases company survival. Standard measures of management effectiveness like return on assets and return on equity are still the first place to go, but they don’t tell the complete story. Excellent management is also identified by the relationships with three key constituencies: customers, employees, and shareholders. Excellence is defined by integrity, respect, and fairness with these three groups. A few examples of how to identify the best and worst companies are given here – there are many others. Choosing investments based on a comprehensive determination of excellence will enable us to be successful in even the challenging times. In addition, we can have the satisfaction of knowing we are associating with individuals that are not only talented, but act honorably and ethically towards others. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Our Top Trades Review – October

Summary A review of our recent Top Trade Ideas. A snapshot of our Current Option Opportunities Portfolio. Several trade ideas that are still great opportunities for new trades. How interesting the markets have been! In our August Top Trade Review , I mentioned we were starting a new product – which began as the 5% Portfolio and was renamed the Options Opportunity Portfolio – which has been a huge success, now up 16.7% at the close of the second month: (click to enlarge) These are, for the most part, short-term trades, but we’ve been layering in some longer-term trade ideas – using our profits to invest in trades that will generate steady monthly gains over time, rather than only focusing on “quickies”. Our Top Trade Ideas generally tend to be longer-term trades, and we don’t have a portfolio that tracks them specifically. They are generally selected trades from the ones that we are adding to PSW’s Short-Term Portfolio or Long-Term Portfolio, and tend to be of the “set and forget” variety, while our OOP trades require a bit more active management. (click to enlarge) While 30 of our first 45 (66%) Top Trade ideas were winners, 4 of our 15 losers were Lumber Liquidators (NYSE: LL ) trade ideas – all of which are now coming back as LL pops back to $20! Hopefully it can break over $20 and we can put all that silliness behind us. Getting two out of three trades right is plenty to move the investing ball towards the goal line. Combine that with sensible portfolio management techniques (diversification, managing losses, hedging), and you’ll beat the S&P by a mile with no sweat. Generally, with our Top Trades, we’re simply picking stocks we feel are underpriced, and we’re using our various options techniques to give ourselves even better discounts and hedged entries – but these are patience plays that do take time to get going, though we did call for a cash-out of our winners in July, so August was kind of a fresh start. Without further ado, here’s the next month of trades for review – some are still good for new entries : (click to enlarge) On August 4th, we saw a news article that Windstream (NASDAQ: WIN ) won a contract for $450M to build out wireless services for the VA. As WIN was a company we had played in the past, this was a trigger for us to jump in with a new play, which was: In the STP, let’s go for 40 WIN Sept $5 calls for 0.50 ($2,000) and let’s do 10 in the $25KP ($500). As you can see, WIN popped nicely right off the bat and finished September 18th (expiration day) at $6.92, with the calls at $1.92 – up 284% . Well, they can’t all be long-term trades… 😉 (click to enlarge) August 11th was a double alert: In addition to a play on Terex (NYSE: TEX ), we also included a long oil Futures trade idea: You can still sell the TEX 2017 $23 puts for $3 and that’s net $19, which is very fair, even if the merger fails – I like that and you can add the $20 ($7.60) /25 ($4.30) bull call spread at $3.30 for net 0.30 on the $5 spread but that’s betting the merger does go through just to make another $1.70 – not really worth the risk. Our timing on that one was good, but then bad, as people first loved, then hated, the merger deal, and now they are warming up to it again. Nonetheless, since we were fairly conservative in our play, the short puts are still just $3.30 (down 10%) , and the additional spread I said was not worth the risk is now net $1.50, down 50%, and NOW it’s worth the risk! A much better trade that day was my Futures pick on oil (/CL) to go long at $43. We pretty much caught the dead bottom there and, as you can see, we popped all the way to $55 before the rally failed – up $12,000 per contract . Of course, we don’t just get in and ride them out – but if you are still in this trade back at $52.50 (up $9,500), it’s time to stop out, as we’re short again! August 24th was our next trade (we didn’t like anything enough in the prior week), and our trade idea that Monday was for our Stock of the Decade, Taser (NASDAQ: TASR ), as it fell back to the $20 line. We liked this one so much that not only was it a top trade, but it was the first long-term trade idea added to our Options Opportunity Portfolio as well: (click to enlarge) Buy 20 TASR 2017 $20 calls at $6.20 ($12,400) Sell 20 TASR 2017 $25 calls at $4.15 ($8,300) Sell 20 TASR 2017 $15 puts at $2.40 ($4,800) Our net on the spread was a $700 credit and, as you can see, this is another one we caught a nice bottom on. They are now back to testing the $25 level, which is all our very conservative target is looking for to make the full $10,700. At the moment, the net on the spread is $2,500, so already net $3,200 off our original $700 credit is up 457% in just over a month, and only just getting started! On August 26th, we got very busy indeed as we reviewed Goldman Sachs’ 25 most oversold stock list to see which ones we thought were playable. Our trade ideas were: (click to enlarge) Cheap food costs tip the scales for me on this one and sure, I don’t like paying 18.8 for a grocery store but I do like paying 12x earnings and that would be $22 and you can sell the 2017 $23 puts for $1.55 to net in at $21.45 (30% off) and we can play that with the $30 ($5.50)/$35 ($3.45) bull call spread at $2.05 to net into the $5 spread for 0.50. Margin on 10 short puts is a negligible $2,300 and I REALLY would like to own $46,000 worth of WFM at $23 so let’s do 20 of those in the LTP . Whole Foods (NASDAQ: WFM ) just took off and headed back to the $35 line, and the net on the spread has gone from $500 to $1,470, which is up $970 (194%) , but merely on trace to the full $5,000 we expect if it can get above $35 and hold it through January 2017. Good time to make a note that you don’t HAVE to make short-term trades to get great short-term returns on your cash. This trade was a very sensible entry on 8/24 and it’s only 10/10 and already we’re up 194% – that’s enough to satisfy all but the greediest of short-term trades yet we took no particular short-term risk because we are BEING THE HOUSE and selling more premium than we bought . (click to enlarge) 10 2017 $35 puts can be sold for $3.20 ($3,200) and $35 is already another 20% off and we can use that money to buy 10 of the $40 ($9.40)/50 ($5.50) bull call spreads for $3.90 for net 0.70 on the $10 spreads that are $4.77 in the money to start. I fully expect these to get cheaper and we’ll spend $4.50 more to roll down to the $30 calls (now $17) when and if we have the opportunity. For the LTP. Marathon Petroleum (NYSE: MPC ) was one we put our foot down on as it tested the $45 line. As we are supposed to do – we took advantage of the OPPORTUNITY to buy low, and we took up an option spread that would give us an entry even lower ($35.70 in this case) in our worst case. As it happens, we nailed the bottom, and already, this $700 spread is netting $3,300 for a $2,600 (371%) gain in just over 30 days. Again, you do not need to take big risks to make big rewards – even in the short run. (click to enlarge) Buy 10 April $40 puts for $2 ($2,000) Buy 10 April $50 calls for $4 ($4,000) Sell 10 Oct $50 calls for $1.55 ($1,550) Sell 10 Oct $45 puts for $2 ($2,000) This Lincoln National (NYSE: LNC ) spread was for our Butterfly Portfolio, and that’s one that needs managing. The long puts and calls are still net $4,900 (down $1,100), but the short puts and calls are down to $560 already (expire next Friday) for a $2,990 gain, and that’s an overall net gain of $1,890 (+77%) off our $2,450 investment in just over a month – not bad for a well-hedged Butterfly! The way our Butterfly plays work is we simply make our next target sale once the first one runs down so, for example, we expect LNC to be around $52.50 into the end of the year and the November options don’t pay well so we can sell the Jan $47 puts for $1.90 ($1,900) and the Jan $53.50 calls for $1.50 ($1,500) and drop another $3,400 in our pocket for the next 3 months. (click to enlarge) On September 2nd, we reiterated our long call on TASR (above) and added this one on Skyworks Solutions (NASDAQ: SWKS ): As we’re always looking for our monthly $4,000(ish) in the LTP, let’s sell 5 of the SWKS 2017 $60 puts for $7 ($3,500) as that’s certainly a stock we don’t mind owning way down from here. While that one got off to a good start, we’re right back where we started (a bit below), at $8.20 for a $1,200 (34%) loss . For the purpose of our LTP, we really do want to own the stock for net $53, so we don’t care what the PRICE (not value) of the option is at $79.60. But this is a patience play for sure. On September 4th, we reiterated our warning to cash out winning positions, and we reviewed all of our Portfolio Positions. As I’ve noted, we don’t have a Top Trade Portfolio, as these trades are mainly picks from other portfolio plays, but the same rules apple – mainly cash and well-hedged is our current position in all 4 of our Member Portfolios! (click to enlarge) Since we had plenty of cash, we were free to add more trades, and on September 9th, we added Yahoo (NASDAQ: YHOO ) with the following spread: Sell 10 2017 $30 puts for $3.80 ($3,800) Buy 10 2017 $25 calls for $8.50 ($8,500) Sell 10 2017 $38 calls for $2.20 ($2,200) YHOO is really only back to where it was on that day after a nasty dip, but once again our “Be the House” strategy pays off, and the net $2,500 entry is already at $3,240 for a $740 gain, which is only +29% – but that’s on a stock that’s gone nowhere in 30 days. Isn’t that a trading style that’s worth learning? (click to enlarge) Our second Top Trade on the 9th was for the only Chinese company we like, China Mobile (NYSE: CHL ), with the following trade idea: While we’re on the top of positions – CHL is up 0.86 today but still cheap at $60.22 and we can sell 5 2017 $50 puts for $3.90 and that drops $1,950 into the LTP and keeps our eye on it . That one has improved since we called it, though off the highs, as China is having a very rough ride (and we knew that, but we still like CHL down here). The $50 puts are now $3.83, or $1,915, on 5 contracts versus the $1,950 we collected, up a not very exciting $35 (2%) , but on track and still great for a new entry. Our other Top Trade ideas are too new to review, but clearly it was a good month, with 8 winners and just two losers (so far), both of which make even better entries now than they were when we called them. Our Option Opportunities Portfolio is a partnership with Seeking Alpha and you can sign up for that portfolio HERE , which aims to make $5,000 a month in a $100,000 portfolio using a variety of option trading strategies (the portfolio at the top of this page is through Friday after just 2 months). It’s similar to Top Trade Alerts but focuses on quicker opportunities that tend to require a bit more active involvement.